Wednesday, April 18, 2018

Buybacks redux

Two more points occur to me regarding share buybacks. 1)When buybacks increase share prices, and management makes money on that, it's a good thing. The common complaint that buybacks are just a way for managers to enrich themselves is exactly wrong. 2) Maybe it's not so good that banks are buying back shares. 3) The tax bill actually gives incentives against buybacks. What's going on is despite, not because.

Recall the example. A company has $100 in cash, and $100 profitable factory. It has two shares outstanding, each worth $100. The company uses the cash to buy back one share. Now it has one share outstanding, worth $100, and assets of one factory. The shareholders are no wealthier. They used to have $200 in stock. Now they have $100 in stock and $100 in cash. It's a wash.

Why do share prices sometimes go up when companies announce buybacks? Well, as before, suppose that management had some zany idea of what to do with the cash that would turn the $100 cash into $80 of value. ("Let's invest in a fleet of corporate Ferraris"). Then the stock would only be worth $180 total, or $90 per share. Buying one share back, even overpaying at $100, raises the other share value from $90 to $100.

That was the big point. Share buybacks are a good way to get money out of firms with no ideas, into firms with good ideas. We want firms to invest, but we don't necessarily want every individual firm to invest. That's the classic fallacy that I think it turning Washington on its head. Best of all we want money going from cash rich old companies to cash starved new companies. Buybacks do that.

1) Management getting rich on buybacks is good.

OK, on to management. Management, buyback critics point out, often has compensation linked to the stock price. They might own stock or own stock options. So when the buyback boosts the stock price, then management gets rich too. Aha! The evil (or so they are portrayed) managers are just doing financial shenanigans to enrich themselves!

The fallacy here, is not stopping to think why the buyback raises the share price in the first place. If it is the main reason given in the finance literature, that this rescues cash that was otherwise going to be mal-invested, then you see the great wisdom of giving management stock options and encouraging them to get rich with buybacks.

There is a strong incentive to keep the money in the firm and invest it on lousy projects. What CEO wants to say "we didn't have any good ideas, so we gave the money back to shareholders!" No! Build solar-powered spaceships to the mars colony! This, in fact, is the classic "agency" problem that managers are prey to: using corporate cash in unprofitable expansions and investments that make the CEO look good but lower the value to shareholders. And now politicians chime in and want you making even worse investments, and excoriating you for giving shareholders back some of their money.

What we need here is... a nice incentive for management to pay out money rather than invest it badly inside the company. And stock price linked pay does that nicely, doesn't it!

Again, the stock price wouldn't go up if the money was going to be invested well in the company. The stock price incentive nicely balances the empire-building incentive.

2) Maybe not for banks.

The other reason companies buy back shares is to lever up more. Suppose our company had $100 of loans as one asset, and $100 of cash from its great trading profits as the other. If it buys back a share for $100, and simultaneously borrows $100, keeping the cash, it turns from a 100% equity financed firm to a 50% leveraged firm. Banks are already 90% leveraged.

Why would a company do that? Well, debt is cheaper because the government bails out debt in bad states of the world. (Wave hands about MM violations).

The financial system fell apart because banks were incredibly over-leveraged. A battle royal has gone on for 10 years to get them to raise more money from equity. They complain "agency costs, we can't issue more equity!" They complain "Our investors are morons, we can't stop paying dividends." OK, but we don't have to let them buy back shares that are already outstanding!

Again, look always for the economic reason for things. If companies are using cash to buy back shares because they don't know what to do with the cash, great. If banks are buying back shares and substituting debt which is artificially cheaper, and brings us back closer to a financial crisis, then not so good.

3) Tax incentives.

Managers and shareholders face a decision: Leave "cash" -- earning interest -- inside the firm, or invested by the firm in other stocks? Or pay it out to shareholders. If you leave cash inside the firm, investors don't pay dividend or capital gains taxes on it right away. But they do pay the corporate tax. So reducing the corporate tax rate to 21% (plus state) from 35%, while leaving individual taxes alone, is actually a pretty big change in incentives toward leaving money inside the company.

I'm a corporate finance and tax amateur, so comments from that quarter are always welcome.

25 comments:

Remember the highly leveraged Long-Term Capital Management. Lately there has been commentary in the blogosphere that some investors, highly leveraged, bought AAA-rated mortgage-backed securities. Evidently some investors out there are leveraging up 30 to 1 and 50 to 1 and of course Long-Term Capital Management was out at 100 to 1.

When those securities declined in value, leveraged investors got punched in the stomach.

I understand the appeal of being highly leveraged. If you bet right you make a lot of money, if you bet wrong you run away.

Evidently, key pillars of our financial system can collapse when highly leveraged investors run into problems.

I don't have any solution to this inherent problem of certain investors becoming highly leveraged. John Cochran suggests that commercial banks not use any leverage, perhaps even mandated by law.

Perhaps the best solution is the one we have now. No regulations against leveraging, but the government does clean up when the financial system collapses.

The buyback issue being more of a metaphor for the wider debate. The 'firm' in the context of a complex set of regulations, each regulation different for the firm structure, and corporations one of many. I have no theory.

This needs to be challenged. The correct answer, I submit, is that "it depends" (and good for whom?).

Let's take your example, but increase the number of shares to 100. The company has $100 of cash and $100 of fixed assets. (The book value of each share is thus $2). Management uses $100 cash to repurchase 50 shares. In total, the book value of outstanding shares (50) is now also $2. The additional demand for outstanding shares in the market may increase the market price temporarily, but we ignore that.

If (prudent) management wants to return un-needed cash to shareholders, the obvious alternative is a (special) dividend. If, instead of the buyback, that $100 is paid as a dividend, ex-dividend there are still 100 shares outstanding, but those shares are now worth $1. Obviously, this is not good news for unexercised management stock options.

So, buybacks are definitely preferred from the management's self-interest in increasing (or, perhaps better, not decreasing) stock price. But, what about shareholders?

Your analysis omits the important step when management exercises stock options. Here, two additional things happen (ignoring complicated financial accounting effects of options). *Except for ISO's*, the company gets a tax deduction for the difference between the FMV of the stock and the exercise price. Second, the company must issue Treasury shares (let's say part of the 100 repurchased) to give to management. This dilutes the other shareholders. (Note that in the "normal scheme", companies use cash to purchase shares used to deliver to option holders). From this perspective, all else equal, the investing shareholders lose compared with a dividend.

As far as tax consequences are concerned, again, "it depends". While the point about the differential between corporate and ordinary individual tax rates is valid as far as it goes, there is much more to consider. The buyback as the notable advantage of allowing existing shareholders to "choose" whether to realize gain from the buyback. Dividends offer no choice. But, the US tax consequences depend on the type of shareholder concerned:

*Note that current US law offers a sizeable exemption for "qualified dividends"--a similar exemption does not exist for CG's.

While the correct answer is "it depends", on balance, I seriously question that shareholders on the whole are better served by buy-backs rather than dividends. Also, it is clear that the tax system provides self-interested management incentives to 1) rely on stock-based compensation rather than ordinary compensation; and 2) use stock buy-backs rather than dividends. This mis-alignment of management/shareholder interests is bound to be abused by the former.

John, you implicitly assume that demands for equities are infinitely elastic. In practice, if demands are indeed downward sloping, the management can still forego positive NPV opportunities and bid up the price of common shares (at least in the short term). I guess everybody objecting against buybacks has in mind something like that.

There is also an extremely simple test for it: if stock prices go back to "normal" months after the buyback buyback critics are right, otherwise we can conclude that the evidence is not concluding.

The 4/19/2018 Daily Shot newsletter has a figure that recent share buyback yields are disappointing. It doesn't look like the narrative is even holding up, in addition to your views that it also isn't a big deal.

(Towards the end of the equities section)http://thedailyshot.cmail19.com/t/ViewEmail/d/60F080B4303EBEDF2540EF23F30FEDED/CB24410DA72D8A8E27D1E72AD0FD8334#Equities

If I understand correctly the new tax code puts limits on the deduction of the interest expense. The result will be that if a highly leveraged company finds that its income calculated on normal accounting principles has declined significantly, it can find that it is paying income taxes on "income" it is not actually earning. Companies that are highly leveraged, and could on an accounting basis survive, may find themselves tipped into a death spiral during a recession by the new tax code.

This risk would be a reason for companies to reduce the use of leverage - indeed that is apparently the intended purpose of the change. We'll see how that works out in the next recession.

To me, the buyback discussion would be less controversial if a bond analogy were used. Nobody objects when bond investors are paid off at maturity. Since stocks have no defined maturity, buybacks or dividends are the only ways to return excess capital to equity holders. Then, as you say, the excess capital is then free to be redeployed elsewhere.

From my perspective item #3 is logical, but ultimately reaches the wrong conclusion. The piece of the analysis you're missing is the mandatory toll charge, which eliminated the existing incentive to stockpile excess cash "offshore" (which in practice just meant you couldn't give it to shareholders; a lot of the cash was actually held in the U.S.).

Now granted, no one really knows how much of this "offshore" cash existed prior to the law change, but credible sources (e.g., Goldman Sachs) reported the amount almost certainly exceeded $3 trillion. Less the 15.5% toll charge, that's an awful lot of share buybacks...

John gives a very learned answer from the traditional Economist's point of view. From a real world perspective, stock prices do seem to rise (frequently) when companies buy back shares. Part of the explanation is not mathematical but behavioral but also fits within the MM framework. When companies buy back shares, especially large repurchases, they are signalling that the Company is in good health and the management is confident about the future. Also that they think the shares are undervalued and therefore a good investment by the company with a positive NPV (and higher than other projects). Finally, investors like the idea of getting cash (indirectly) and they reward those companies. It is effectively an increase in the dividend which should increase the value of the stock under the DDM. All of these would justify an increase in the value of the company--a violation of MM.

Now in theory this should not increase stock prices post buyback, because past buybacks should not suggest a higher likelihood of future buybacks. But in practice, for whatever reason, that's not how the market sees it: firms that make buybacks once are perceived as more likely to make future buybacks.

One thing you're missing is that many managers have incentive compensation linked to EPS, not share price. Buying back shares is a way to shrink the outstanding share base and boost EPS without any real gain in earnings. You can do the math, but for a CEO running a company with $100 cash, $100 earnings and 100 shares outstanding it makes more sense for him to invest the cash in a share buyback than an investment with a year 1 return of 10%. The calculation changes depending on the return rate of the investment, but it's something that CEOs are incentivized to consider regardless of the theoretical cost of equity.

First, I question how "many" managers have incentive compensation linked to EPS. Do you have any data on that? Second, even those that do would typically have a clause that indicates EPS will be adjusted for changes in capitalization (managers want to be protected from share issuances as much as they might want to benefit from share buybacks). While I can't rule out that such a one-sided provision in an incentive contract might exist (and be abused), I seriously doubt they are commonplace. Also, such a one-sided provision would open one up to shareholder suits.

While I agree that such a contract provision as mentioned by Zachary would be "dumb" (from the perspective of shareholders), I think that as regards executive compensation generally (and decisions that are made to subsequently manipulate contract value (e.g. share buybacks versus dividends), it appears that you think there are strong and effective provisions in place to ensure "dumb" contracts (from the shareholder perspective) are not entered into.

Step back a moment and consider who in the realm of corporate governance negotiates and confirms those contracts? Senior executive management and the Board of Directors. I do believe that about 98 percent of members of the boards of US publicly traded companies are also granted stock options (under generally the same terms as direct management). Dodd/Frank requires shareholder advisory vote on compensation arrangements, but in practice even that provision has little bite.

I am still waiting for someone to make an effective argument as to why share repurchases should be considered superior to dividends as a means of returning cash to shareholders (and ultimately to a better home to invest that money).

"I am still waiting for someone to make an effective argument as to why share repurchases should be considered superior to dividends as a means of returning cash to shareholders (and ultimately to a better home to invest that money)."

I will give it a shot. Below, I explain a big difference between share buybacks and dividend payments. Which method is better than the other is in the eye of the beholder. And please remember, share buybacks / dividends are not always funded out of free cash flow - they can be funded through a number of other channels (for instance borrowing).

Share repurchases observe market price principles - both the share holder and the company must agree on the price paid for the company to repurchase the shares. Share repurchases can fail if the buyer and seller cannot come to an agreement on price. This rarely (if ever) happens with widely traded and held stock. But for thinly traded securities with just a handful of owners, this can be problematic and quite contentious (especially when voting shares are in play).

Dividends are not negotiable from the shareholder's perspective. They are often set and fixed by the CFO / Board of Directors. As such, they might not observe market price principles.

As a voting shareholder, I may prefer dividends over share repurchases so that I can maintain a voting control in the future of a company.

As a non-voting shareholder, I may prefer share repurchases over dividends if those dividends are only paid out on voting shares.

@ anonymous: whether thr company pays $100 of comp in options or cash is a matter of indifference. Either the company is out $100 of cash or the shareholders are diluted in the same amount doesn't matter.

Similarly, buybacks don't inherently create more valuable shares. Instead, to the extent they increase prices it's because they signal to the market that the company is bullish on itself.

Viv - share buybacks are considered superior because they don't have to be recurring. A comppany that cuts a dividend will be punished for it, while that same company can adjust buybacks up and down each year without the same market scrutiny if buybacks are pared back.

The board of directors is considering a stock buy-back of 10,000 shares at a net cost of $100,000 (to be covered by cash on hand) and will announce the buy-back offer immediately upon an affirmative decision by a majority of the board of directors to be undertaken over 3 months commencing in 4 weeks of the announcement. The VP-Finance presents her findings to the board of directors in a circular memorandum ahead of the regularly schedule board meeting. She makes the following points in her memorandum:1.) Market price of 1 share pre-buy-back is $10.002.) Buy-back cost, net, is $100,000 which will reduce Net Financial Assets from $350,000 to $250,000.3.) Market value of the equity will be reduced from $10,350,000 to $10,250,000.4.) Shares outstanding after the buy-back if 10,000 shares are acquired through the buy-back and no shares are issued or re-issued will be 1,025,000.5.) Market price of the common shares after the buy-back will be $10.00 (= $10,250,000 divided by 1,025,000 shares outstanding).6.) The purpose of the buy-back is to return capital to the shareholders tax-efficiently for the participating shareholders.7.) The regular quarterly dividend rate per outstanding share is expected to be maintained at the current rate, $0.02 per share during and following the buy-back period.

One could recast the scenario with a Net Debt position instead of a Net Financial Asset position, and as long as the market's expectations for income, cash flow and going-concern status is unchanged, the share price should remain unchanged on an expected value basis. The board of directors will vote for the proposal if there is no alternative use for the cash.

There's little opportunity for game playing here. If the market perceives that management is lining its own pocket at the expense of the shareholders, the value of the enterprise will diminish and the stock price will decline. The reason is to be found in the expectation of the present value of future net cash flow of the firm that forms the greater part of enterprise value and the price of the common shares outstanding. The present value expectation is adjusted downward in that instance.

In a fair game, the stock buy-back is neutral. In a rigged game, the buy-back is negative. Does this answer your query?

David, That is an interesting and useful perspective. I would only add that post buybacks, the total amount of dividends being paid out declines, assuming that dividends per share remain constant.

If I understand the accounting, that means the pay-out ratio going forward declines and that should make the stock look more attractive to risk neutral and risk averse ordinary shareholders assuming the opportunity cost/expected return on firm capital investments stays the same. -Erik

In a buy back, the shareholder gets to choose to participate. Often the decision is to take the capital gain and pay tax. If the shareholder declines, they generate no taxable event. With a dividend decision a taxable event is inflicted on all shareholders. Plus the previous point on expectation and adjustmment differences.

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This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!